World still sniffles and we feel a chill

The world economy is recovering, but as the International Monetary Fund’s
Christine Lagarde
puts it, the recovery is “too weak for comfort".

Global growth has been slowing since 2010. The IMF estimates the growth last year was half a percentage point below the long-term average, notwithstanding the massive spare capacity available for the recovery.

The new “roadblocks" to stronger growth, according to Lagarde, are the risk of prolonged very low inflation – which restricts the ability of central banks to cut real interest rates and raises the risk of deflation – as well as increased financial market volatility and geopolitical tensions.

New analysis published by the IMF last week also raises the possibility that, with the recovery of the advanced economies from the global financial crisis still weak, output and growth in the emerging market economies may have suffered enduring damage.

The research shows that growth in more than half the emerging market economies is now slower than previously would have been expected given the current global economic conditions.

“The findings suggest that emerging markets are facing a more complex growth environment than in the period before the [global] crisis," the IMF warns.

For Australia, the risk of a prolonged period of stunted global growth is a new overlay on its already declining terms of trade and the slower than expected transition from the mining investment boom to more broadly based growth.

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Politicians everywhere are being confronted by the ghosts of spurned reform – both in the advanced economies, where the scope for supportive macro-economic management is narrowing, and in the emerging market economies where the need for hard reform is no longer masked by the availability of easy money.

Global issues

The United States still needs a medium-term fiscal plan, while the euro area lacks a common fiscal backstop, and Japan has yet to deliver its promised micro-economic and fiscal reforms.

China’s new leadership is accelerating the long-postponed economic restructuring, but finds itself struggling with the side effects of China’s massive economic stimulus – side effects that have been made worse by the delays in structural reform.

In Australia, too, the Abbott government is grappling with a stubbornly large budget deficit and suddenly finds itself staring into the political minefield of tax reform.

Treasury secretary
Martin Parkinson
last week caused a minor sensation with a speech that laid both the challenges facing the Australian economy and the dangers they pose to the future growth of living standards.

The challenges should be familiar. They include the economy’s weakened productivity performance, the falling terms of trade, demographic change, and the structural budget deficit.

However, pulling them all together in one speech has a shocking effect, not least because of the compelling case it makes for expanding the goods and services tax.

Australia is facing a return to the weak per capita income growth rates of the troubled 1970s.

True, per capita income will still be very high if the decline in the terms of trade is as moderate as the Treasury suggests. But that won’t save industries that depend on income growth.

Chief among those industries is the government itself. It faces rapidly rising demand for publicly provided services but, in the context of stagnating incomes, even stronger resistance to higher taxes.

Slowdown in income growth

The projected slowdown in income growth is driven primarily by the decline in the terms of trade, population ageing and a continuation of the lower post-1990s rate of productivity growth.

As the accompanying graphs show, those effects can be offset only by productivity growth accelerating to an average of 3 per cent a year – a rate that was not achieved even in the very high growth of the 1960s, and almost certainly is unattainable now.

Governments cannot rely on the economy’s growth to lift the budget painlessly out of its current deficit.

The budget is on track to remain in deficit for another 10 years, which would mean 16 straight years of deficits, with the federal government’s net debt rising to about 15 per cent of GDP.

That of itself is hardly ruinous but, as Parkinson says, it makes us less able to protect the economy in the event of another major downturn.

Hopefully, the lessons learned from the global financial crisis will break the cycle of increasingly frequent and destructive financial crises (although there are of economists who question even that), but no one pretends to have abolished the business cycle.

We should count on having a recession sometime in the next 10 years and, as Parkinson puts it, “unless we recharge our fiscal buffers we will find ourselves increasingly vulnerable to global shocks."

Courage required

But recharging the fiscal buffers will require great political skill and courage.

Parkinson points to the apparent ease with which the New Zealand government increased its GST rate from 12.5 to 15 per cent with virtually no exemptions. But even an increase in the GST fully offset by cuts in personal income tax is almost a taboo for Australian politicians.

Another productivity-boosting initiative that has been embraced by the Abbott government – increased investment in infrastructure – sounds easier. But that too will require more discipline in the choice of projects than our politicians have become accustomed to.

Moreover, Treasury research has shown that increased productivity growth in the private sector alone won’t do much to lift government revenues and cut the deficit. There also will have to be a further increase in productivity in the public sector, which will require reforms to government services that politicians have been shirking for years.